Why the Fed raised rates too fast

This is a weird argument. Subprime adjustable-rate mortgages only became popular in the first place because of the irrationally low level of short-term interest rates. The Fed didn’t really sledgehammer the subprime sector, so much as raise interest rates back to where they ought to be.

I have no idea where rates ‘ought to be’. I do think, though, that the Fed raised rates too fast (which is a bit different than what I said in my previous item, that they raised too much). Four percentage points in two years means that they were raising rates faster than the economy could react, keeping in mind that it takes 12-18 months for rate changes to have their full effect.

In retrospect, it’s pretty clear that Greenspan and Bernanke would have been better off raising two percentage points off the bottom, and then slowing down the increases to give borrowers time to adjust. That surely would have led to a better outcome than what we are getting now.

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Reader Comments

Lord

February 11, 2008 05:18 PM

Looking at the credit market, as the Fed tightened, lending standards were progressively loosened. That doesn't seem like too fast to me. It wouldn't say much about markets if they couldn't anticipate the increases. Now they may not have known just where they would stop and assumed they would stop earlier, but even that seems questionable. Prices were based on future appreciation and when that no longer existed, they had to decline. With many loans on teaser rates and not even resetting yet, rates hardly came into play. More likely they knew the party was coming to an end and did everything in their power to have one last blast before the bubble collapsed. Now if the Fed had moved slower, the bubble would have inflated even more, but it is very hard to see how it could avoid collapsing.

kio

February 12, 2008 03:16 AM

When you say "12 to 18 months for rate changes to have their full effect", do you really mean that there exist an elevated correlation between the change in the Fed's rate and some clear change in inflation (output, etc.).
It is a very interesting statement. I would appreciate you you could provide me with the references on this correlation. When I regress rate/inflation time series I am able to obtain a somewhat higher correlation for inflation leading the Fed's rate by 6 to 9 months.

Ned

February 12, 2008 12:45 PM

Kio: Without looking at a single number I'm not at all surprised that you would find a higher correlation for inflation leading the Fed than for the Fed's impact on any particular economic variable. When the Fed sees inflation rising, they raise rates. That's a much more direct cause and effect relationship that the effects of monetary policy on the economy.

Ralph

February 12, 2008 02:22 PM

The issue is less the rates, although they certainly played a role,it is the underwriting criteria. Lenders began acting like methadone maintenance clinics for heroin addicts. Now the methodone has been taken away and the addicts have been left in place. The securitized lending market was the driving force that put prices of housing at a value to fundementals relationship that is practically double the relationship that exisited during the boom in prices during the 1980's. With current the pull back from the lenders in real estate, there is no longer a "catalyst" to drive prices higher, which probably means that prices will fall. Since housing prices have further to fall to get closer to where the fundementals justify price than we had in 1980's, we could be looking at a pretty severe downturn in the housing and real estate financing markets for several years.

kio

February 12, 2008 03:53 PM

Just read famous
http://research.chicagogsb.edu/gfm/events/conferences/2007-usmonetaryforum.aspx

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Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.